CPI Shows Inflation May Be a Bigger Problem than the Fed Thinks It Is

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A hodge-podge of government reports released Friday has rekindled debate amongst economists over a question central to the future of the U.S. economic recovery: Is inflation slowly on the rise, or is deflation about to sink prices and future growth?

The consumer price index (CPI) rose for the first time in four months in July, signaling higher prices in some sectors and easing concerns that a slowdown would sink the U.S. economy into deflation. Meanwhile, the government released a string of weak economic reports that point to slower economic growth.

The consumer price gauge increased 0.3%, the most in a year, outpacing the 0.2% gain projected by the median forecast of economists surveyed by Bloomberg News, figures from the Labor Department showed Friday. The so-called core rate favored by government economists, which excludes volatile food and fuel costs, met expectations, increasing 0.1%.

Separately, a report from the U.S. Commerce Department showed retail sales rose for the first time in three months during July, but less than forecast, indicating the lack of jobs is prompting Americans to rein in spending. Purchases increased 0.4%, narrowly led by sales of autos and gasoline. Excluding auto dealers and service stations, demand dropped 0.1%.

Meanwhile, consumers were apparently feeling better, as a measure of consumer sentiment exceeded expectations, increasing to 69.6 in August from 67.8 in July, according to a Thomson Reuters/University of Michigan survey.

The numbers have spurred many economists to speculate about what actions, if any, the government should take now.

Deflation can become a dangerous spiral in which consumers are encouraged to save more on expectations they can buy goods and services later at a lower price, thus hurting the economy.

In response to a weak unemployment report and other data, Fed policymakers this week left the overnight interbank lending rate target in a range of zero to 0.25%, right where it's been since December 2008. The central bank also said it would resume small purchases of government debt as it attempts to counter the economic slowdown.

Some economists say the lack of inflation reflected in the CPI numbers gives Fed policymakers enough cover to leave the benchmark interest rate near zero into 2011 to stimulate the economy.

Compared to July 2009, consumer prices are up only 1.2%, just slightly higher than the 1.1% year-on-year rise in June. Excluding food and energy, consumer prices in July were just 0.9% higher than a year earlier, below the Fed's informal inflation target of between 1.5% and 2.0%.

"Prices are not rising very rapidly but they are not falling either," Naroff wrote in an email to clients.

"The recovery is steadily progressing, regardless of what the Fed thinks. Consumers and businesses are spending, it's just that too many people expected more," said Naroff. "That will happen, but later rather than sooner. And when that occurs, prices will rise more rapidly. A year from now, we will likely be worrying about inflation."

Other analysts agree the danger may be on the inflation side of the coin.

"There's been some firming in core inflation in recent months," Julia Coronado, a senior U.S. economist at BNP Paribas in New York, who accurately forecast the 0.3% gain in the overall prices told Bloomberg. "This takes some pressure off the Fed in terms of deflation."

Naroff believes the Fed's warning of a faltering economy was a mistake because it perpetuates a self-fulfilling prophecy where consumers won't loosen their pocket books because of all the negative news.

"Consumers are not particularly happy about their lot in life and they are acting accordingly. This negative feedback loop is hurting and the Fed's sudden recognition that we are not in a rapid recovery didn't help." he said. "The recovery is not faltering. The reality is that we have had modest growth for the past year, nothing has changed in the past three months and little is likely to change…this recovery needs time so that the damage from the housing and financial sector meltdowns can be healed further and the impression that a slow but steady upturn is sustainable can be created."

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